Image Credit: Bitcoin.com
If anything was going to force me to actually write something, it was going to be XRP. The SEC started a legal action against Ripple on December 22, 2020, with an amended complaint filed on February 18, 2021. Fact discovery was completed by August 31, 2021, and expert discovery ended on February 28, 2022. On March 11, 2022, the court denied the SEC's motion to dismiss Ripple's defense that it wasn't aware its actions were illegal. That same day, the court also refused to dismiss separate motions by Garlinghouse and Larsen. On March 6, 2023, the court partly granted and partly denied motions to preclude expert testimony. Today the court handed down their decision regarding the dueling motions for summary judgment, and, perhaps most importantly, had this to say:
Quick Summary of The Ws and Ls
First, the L: Direct Sales to Investors.
The court held that the direct sale of XRP to institutional investors constituted an investment contract and, therefore, an unregistered sale of securities.
Investment of Money: the institutional buyers indeed invested money by exchanging fiat or other currency for XRP.
Common Enterprise: the court found evidence of “horizontal commonality,” or the tying of each investor’s fortunes to the success of the overall enterprise and other investors. When the value of XRP increased, all buyers profited proportionately. Hence, horizontal commonality.
Reasonable Expectation of Profit: the court found that reasonable investors would have bought XRP expecting to profit. This expectation was fuelled by Ripple’s communication and marketing campaign, which connected XRP’s price and trading to its own efforts and was also exemplified by the willingness of investors to lock up their positions for a period of time post-sale (which would be an unreasonable thing to agree to unless the investor believed that the value of the locked up assets would increase during that time).
Efforts of Others: the court determined that Ripple had marketed XRP as an investment tied to the company’s success, based on evidence from promotional brochures and reports circulated to investors, and public statements made by senior Ripple executives. Ripple used the funds it received from its institutional sales to promote and increase the value of XRP, therefore the reasonable expectation of profits derived from the efforts of Ripple (others).
In conclusion, the court found that Ripple's institutional sales of XRP met the criteria of the Howey test, suggesting that these transactions could be deemed as securities.
Now for a W: Sales on Exchanges.
The court held that the “Programatic Sales” of XRP did not amount to an investment contract and, therefore, did not constitute the sale of securities.
Specifically, the court found that “Programmatic Buyers,” who engaged in blind bid/ask transactions on exchanges, could not have reasonably held an expectation of profit.
Despite the SEC’s argument that Ripple targeted speculators, the court argues that a speculative motive does not imply the existence of an investment contract within the context of the Securities Act. It’s not the speculative motive but whether this motive is derived from the entrepreneurial or managerial efforts of others, such as Ripple, that matters. Programmatic Buyers might have bought XRP expecting a profit, but they were not necessarily aware they were buying XRP from Ripple, nor were they influenced by Ripple’s efforts.
The court states that the focus should be on the promises and offers made to investors, rather than individual motivations. In the case of Programmatic Sales, Ripple did not make any promises or offers, because neither Ripple nor the purchasers knew who they were dealing with.
Another W: Protocol-level Distributions and Team Grants
The court found that “Other Distributions” - which include distributions to employees as compensation and to third parties as part of Ripple’s Xpring initiative - do not satisfy the first prong of the Howey test, “investment of money” as part of the transaction or scheme. The Howey test stipulates that investors should provide capital or cash as part of the transaction.
Recipients of the “Other Distributions” did not pay money or any tangible or definable consideration to Ripple. On the contrary, Ripple paid XRP to these employees and companies. Moreover, the court found that there was no factual evidence to support the SEC’s claim that “Ripple funded its projects by transferring XRP to third parties and then having them sell the XRP,” and rejected the notion that the “Other Distributions” were an indirect public offering since the parties that received XRP from Ripple could transfer their XRP in exchange for units of another currency, goods, or services.
So, what does this mean going forward?
I think the moral ends up being:
Issuers should not undertake direct sales (especially presales) of digital assets to investors without ensuring that they are complying with an exemption from registration as a security.
Selling digital assets via exchanges seems to really be off to the races.
Native distributions at the protocol level and payment of service providers in the form of a native digital asset looks to have the green light.
Now, there is a very good chance that the SEC looks to fight this loss, so web3 projects should not let their guard down. Nevertheless, I think it is healthy to take the wins when you can get them, and today’s decision was a very nice win.
What kind of lawyer would I be without a disclaimer?
Everything I post here constitutes my own thoughts, should only be used for informational purposes, and does not constitute legal advice or establish a client-attorney relationship (though I am happy to discuss if there is something I can help you with). I can be reached via email at david@bsl.group or dlopez-kurtz@crokefairchild.com on telegram @davidlopezkurtz on twitter @lopezkurtz and on LinkedIn here.